Chapter 67: Floating exchange rates (3.2)

Transcription

1 Chapter 67: Flating exchange rates (3.2) Key cncepts Definitin f exchange rates Flating exchange rate regime Appreciatin and depreciatin Supply and demand Determinants f a flating exchange rate Trade flws Relative inflatin FDI and prtfli investment Dmestic grwth Grwth in trade partners ecnmies Speculatin Other determinants Deficits and debt Purchasing pwer parity (PPP) thery Effects f the exchange rate n Dmestic AD and GDP Inflatin Unemplyment Balance f payments Current accunt Gvernment debt Determinatin f freely flating exchange rates Causes f changes in the exchange rate Explain that the value f an exchange rate in a flating system is determined by the demand fr, and supply f, a currency Draw a diagram t shw determinatin f exchange rates in a flating exchange rate system Describe the factrs that lead t changes in currency demand and supply, including freign demand fr a cuntry s exprts, dmestic demand fr imprts, relative interest rates, relative inflatin rates, investment frm verseas in a cuntry s firms (freign direct investment and prtfli investment) and speculatin Distinguish between a depreciatin f the currency and an appreciatin f the currency Draw diagrams t shw changes in the demand fr, and supply f, a currency The effects f exchange rate changes Evaluate the pssible ecnmic cnsequences f a change in the value f a currency, including the effects n a cuntry s inflatin rate, emplyment, ecnmic grwth and current accunt balance

2 Intr questins: 1. If the USD t the Yuan ges frm USD1 = 6.3 t USD1 = 6.1, the Yuan has in fact becme strnger. Use wrds t explain this. 2. The USD wuld if US relative inflatin were t fall. The USD wuld if US husehlds were t see increased incmes. 3. Hw might the USD be affected by Apple, Micrsft and Cca Cla repatriating hundreds f billins f earnings frm abrad? 4. Incmes in Canada and Mexic increase hw will this affect the USD? 5. An appreciatin f the British pund ( ) culd cause a in D, a in Y, a in unemplyment and a in current accunt in the balance f payments (BP). 6. Using diagrams, explain hw the exchange rate fr the might be affected if speculatrs and investrs believe that it is vervalued. 7. Hw might the Eurpean Central Bank (ECB) react t the effects utlined in yur answer abve?

3 Definitin f exchange rates Definitin: Exchange rate The exchange rate is the price f a currency expressed in terms f anther currency. Thus the exchange rate fr the US dllar can be expressed in the amunt f British punds, EURO r Mexican pess needed t buy ne dllar. (The exchange rate can als be expressed as the price f a currency against a basket f ther currencies.) Nte that when we refer t the exchange rate fr the dllar we use the price f the US dllar in terms f, say, punds. The exchange rate fr the pund wuld naturally be expressed as the price f punds in anther currency here, US dllars. Thus; 1 = USD1.58 and USD1 = Three main shrt run determinants f exchange rates exist: 1. The demand fr ther cuntries gds and services: When Eurpean turists visit the US they will need US dllars and Eurpean citizens wanting mre US gds will be met by Eurpean imprters increasing their demand fr US dllars in rder t buy US gds. 2. The demand fr FDI and prtfli investment in anther cuntry. 3. Speculative demand: When internatinal speculatrs such as fund management firms and ther financial institutins believe that the EURO will appreciate, they will buy EUROs in rder t make a gain in selling them when the EURO rate rises. Flating exchange rate regime Definitin: Flating exchange rate A flating exchange rate is when a currency s price (in terms f ther currencies) is ttally determined by market frces e.g. supply and demand fr the currency. Appreciatin and depreciatin Appreciatin: When the market value f a freely flating currency increases, i.e. the market price has increased, the currency has appreciated. This can be caused by an increase in demand and/r decrease in supply f a currency n the freign exchange market. Depreciatin: When the exchange rate (expressed in terms f anther currency r a trade-weighted basket f currencies) fr a freely flating currency falls, then the currency has depreciated. Increased supply and/r decreased demand will cause depreciatin. Definitin: Appreciatin and depreciatin When the exchange rate f a freely flating currency rises, the currency has appreciated. A fall in the price f a flating currency against anther currency (r basket f currencies) means the currency has depreciated.

4 Supply and demand The supply curve fr a currency is upward slping and the demand curve is dwnward slping. Using the EURO t explain why: Demand: A lwer price fr the EURO ceteris paribus wuld enable freign citizens t buy mre EURO zne gds, and freigners wuld thus demand mre EUROs. A lwer price f the EURO is thus crrelated with an increase in the quantity demanded fr EUROs. Supply: The supply curve fr the EURO is upward slping since a higher price fr it means EURO zne citizens can exchange their EUROs fr mre freign gds. As EURO zne citizens trade in their EUROs fr ther currencies, the quantity supplied f the EURO increases and we get psitive crrelatin between the price f the EURO and quantity supplied f the EURO. Figure 67.2 The exchange rates fr the EURO and the US dllar (USD) I) EURO II) USD P f in USD 1.35 S Initial equilibrium: 1 = 1.31 USD and thus 1USD = 0.76 P USD in 0.76 S0 S D0 Q0 Q1 Q (millins/day) D1 New equilibrium: 1 = 1.35 USD and thus 1USD = 0.74 Q0 Q1 D Q$ (millins/day) Diagram I in figure 67.2 abve shws hw an initial equilibrium in the exchange rate fr the EURO is set at USD1.31. This gives an exchange rate fr the US dllar f 0.76, shwn in diagram II. Say that there is increased American demand fr Eurpean gds r an increase in American turists t Eurpe: EURO: the demand fr EUROs will increase frm D0 t D1 in diagram I, and the exchange rate fr EUROs appreciates frm USD1.31 t USD1.35. USD: As mre US dllars wuld flw int freign exchange ffices t buy the EURO, the supply f US dllars wuld increase. This is shwn in diagram II, where the supply f US dllars increases frm S0 t S1, and the exchange rate fr the US dllar depreciates frm 0.76 t The new exchange rate fr the USD is naturally the inverse f the price f the EURO (1 / 1.35).

5 POP QUIZ 4.6.1: INTRODUCTION TO EXCHANGE RATES 1. The exchange rate fr the US dllar is 7.8 Swedish Crwns (SEK). What is the exchange rate fr the SEK? NOTE: changed the price f the USD. 2. What will happen t the exchange rate fr the Japanese Yen if mre turists visit Japan? 3. What will be the effect n the Japanese exchange rate if Japanese imprts rise? 4. Farawayistan places a large quantity f embassy persnnel in Nearistan. These persnnel buy lts f gds and services frm Nearistani firms. Explain what will happen n the freign exchange markets in terms f Faraway dllars and Neari punds. Determinants f a flating exchange rate US dllar; change in demand US dllar; change in supply P f $US (TWI) S P f $US (TWI) S2 S D S1 D2 D0 D Q2 Q0 Q1 Q$ (millins/day) Q2 Q0 Q1 Q$ (millins/day) Increase in demand fr the US dllar: D fr US exprts f gds/services in US inflatin rate (ceteris paribus) D fr freign investment in US Y fr trade partners in US interest rates speculative buying f US dllar Decrease in demand fr the US dllar: D fr US exprts f gds/services D fr freign investment in US Y fr trade partners in US interest rates in US inflatin rate (ceteris paribus) Increase in supply f the US dllar: D in US fr imprts f gds/services in freign inflatin rate (ceteris paribus) D fr US freign investment abrad Y in US (dmestic grwth) in freign interest rates speculative selling f US dllar Decrease in supply f the US dllar US imprts f gds/services in US freign investment abrad in freign interest rates in freign inflatin rate (ceteris paribus) speculative selling f US dllar

6 Trade flws demand fr gds and services (refer t figure 67.4) When American exprts increase, there will be an increased demand fr the dllar as imprters in ther cuntries will need mre dllars t buy the American gds. The same ges fr services and turism; mre banking services and turism demanded by trade partners mean greater demand fr the US dllar. D fr US exprts demand fr USD appreciatin f the USD US imprts supply f USD depreciatin f the USD Relative inflatin (refer t figure 67.3) Increase in relative inflatin: relative inflatin in US demand fr US exprts & US demand fr imprts demand fr US dllar & supply f US dllar USD depreciates Decrease in relative inflatin: relative inflatin in US demand fr US exprts & US demand fr imprts demand fr US dllar & supply f US dllar USD appreciates. FDI and prtfli investment (refer t figure 67.3) One f the main reasns fr the phenmenal appreciatin f the US dllar during the 1990s was that it was s attractive fr freign firms t invest in the US. Strng grwth, high prfits and a dynamic and innvative envirnment attracted billins f investment Yen/EUROs/British punds. In rder t build a plant in the US r buy American shares, ne must first buy US dllars; demand fr dllars increases and the dllar will appreciate. Psit then that ne r mre f the fllwing happens: prfits in US cmpanies rise; US crprate taxes are lwered; US prductivity increases; r legislatin is limiting freign wnership in the US is scrapped. inflws f investment t US demand fr USD US dllar appreciates Cnversely, when American firms set up factries abrad and US investrs increase their hldings f Eurpean/Japanese bills, bnds and shares, Americans will have t buy ther currencies in rder t make these exchanges. US investment abrad supply f USD US dllar depreciates Dmestic grwth (refer t figure 67.3) Change in natinal incme: As has been pinted ut, when incmes rise there is an increase in spending in husehlds. Sme f this spending will f curse be n imprts. Y in the US imprts in the US S f USD US dllar depreciates Grwth in trade partners ecnmies (refer t figure 67.3) An increase in natinal incme in Mexic, ne f America s main trading partners, will naturally mean increased exprts fr the US and an increase in demand fr US dllars. Y in Mexic demand fr US exprts D fr USD US dllar appreciates

7 Speculatin (refer t figure 67.3) Speculative belief that the US dllar will depreciate US dllar is sld by speculatrs supply f the US dllar the USD depreciates Speculative belief that the US dllar will appreciate US dllar is bught by speculatrs demand fr the US dllar the USD appreciates Other determinants (refer t figure 67.3) As mentined in Chapter 57, ne main determinant f a flating exchange rate is the level f gvernment deficits and debt an ecnmy has. Anther thery dealing with the lng run determinants f exchange rates is the thery f purchasing pwer parity (PPP). PPP exists when an identical basket f gds csts the same in tw cuntries at a given exchange rate; at an exchange rate f USD1 = 0.75 a bundle f gds csting USD100 in the US wuld cst 75 in the EU since there wuld be perfect parity between the purchasing pwer f a US dllar and that f a EURO. Assuming perfect flws f gds, mney and infrmatin between trading natins, dmestic cnsumers will detect price differentials and act upn them. Say the bundle csts 70in EMU cuntries at an initial exchange rate f USD1 = $0.75. Americans wuld get 75 and buy mre gds frm Eurland which wuld drive up demand fr the EURO whilst simultaneusly increasing the supply f the USD. Ultimately the EURO wuld appreciate (and the USD depreciate) and the price differentials wuld be eradicated, resulting in an exchange rate where the bundle f gds is the same price in the US as it is in Eurland. 1 The thery f purchasing pwer parity thus predicts that exchange rates will ultimately even-ut t reflect changes in inflatin in trading cuntries. In ther wrds, in the lng run PPP will ultimately be restred via the exchange rate. Definitin: Purchasing pwer parity (PPP) thery The thery f purchasing pwer parity states that exchange rates will in the lng run adjust t different inflatin rates in cuntries, leading t equilibrium where a given amunt f hme currency traded fr a freign currency will buy an equally-sized bundle f gds. The thery is used as a pssible explanatin f lng run influences n the exchange rate. Hwever. while there is sme evidence that exchange rates in the lng run shw sme adjustment t purchasing pwer, there are far t many exceptins abunding t be able t draw general cnclusins. The limitatins set by the assumptins f the thery wuld appear t be quite strng. Many gds are like ill-mannered infants and saké (Japanese rice wine); they simply dn t travel well e.g. services such as restaurant meals and cinema tickets are nt exprtable and many gds will have high transprt csts and als meet high trade barriers. Gds are nt hmgenus and thus price differences will exist which shw cnsumer preferences. 1 In this case the 70 bundle must equal the USD100 bundle in price at the new exchange rate. This implies a PPP exchange rate f USD1 = 0.70 which cnsequently means that the EURO has appreciated frm 1.33 t 1.43 dllars per EURO.

8 In additin, expenditure taxes can vary cnsiderably between cuntries and internatinal firms will indulge in price discriminatin whenever pssible. Pint in fact, a survey f the mst integrated single market in the wrld, the Eurpean Unin, shwed that prices f cinema tickets varied by 170% between lwest and highest prices in the EU. 2 Anther example is Switzerland, which is surrunded by 5 cuntries (including Liechtenstein) and has relatively pen brders twards its EU neighburs yet it is ne f the ntriusly mst expensive cuntries in the wrld, where a basket f gds csts an average 40% than the OECD average. These are but a few examples f hw purchasing pwer parity thery cmes up a bit shrt in predicting that exchange rates will adjust and eventually even-ut prices. POP QUIZ 4.6.4: EXCHANGE RATE DETERMINANTS 1. Eurpean tastes switch in favur f East Asian culture and gds. What wuld happen n the freign exchange market fr the EURO? 2. Say that Britain grants tax hlidays fr freign firms. Hw wuld this affect the exchange rate fr the British pund? 3. Krea manages t keep its inflatin rate lwer than that f its trading partners. Hw might this affect the Krean Wn? 4. The Eurpean Central Bank (ECB) cnsiders the exchange rate fr the EURO t be t lw. What actins can be taken? 5. Here s a tricky ne: Using a S/D diagram fr the Swiss Franc, shw hw the repatriatin f prfits t Switzerland by Swiss firms in Germany wuld affect the value f the Swiss Franc. Effects f the exchange rate n macr gals This is ecnmics s the dds are fair that any tw variables will shw causal flws in bth directins. This is indeed the case where currency depreciatin/appreciatin will affect dmestic grwth, inflatin, unemplyment and the balance f payments. Dmestic AD and GDP Depreciatin f the USD relative P f exprts in the US US exprt revenue AD relative P f imprts in the US US imprt expenditure AD 2 The flaw f ne price, The Ecnmist, Oct 16 th 2003

9 Inflatin Appreciatin f the USD relative P imprts in the US US imprts AD inflatin rate US firms imprt a majr prtin f factrs P imprted factrs AS inflatin rate It is als likely that the increased cmpetitin with freign suppliers will frce US firms t becme mre price cmpetitive and this t will have a dampening effect n US inflatin. Unemplyment Depreciatin f the USD exprts in the US AD unemplyment Appreciatin f the USD and thus exprts AD in the US unemplyment Balance f payments We will deal with the balance f payments in sme depth in Chapters 70 t 73 s fr the time being we shall limit the iteratin t tw brief examples f hw a change in the exchange rate can have an impact n net exprts in current accunt. Current accunt Depreciatin f the USD (relative) P f US exprts US exprt revenue imprvement f current accunt balance (relative) P f imprts in the US US imprt expenditure imprvement f current accunt balance Appreciatin f the USD (relative) P f US exprts US exprt revenue wrsening f current accunt balance (relative) P f US imprts US imprt expenditure wrsening f current accunt Gvernment debt We nt directly ne f the main macr bjectives, it is clearly desirable fr cuntries t ultimately balance the budget. A gvernment which has taken freign lans will have t service this debt (i.e. pay interest and repay the principle lan) in the freign currency f the creditr natin. A depreciatin f the Hme currency means an increased debt burden in terms f the freign debt element f verall gvernment debt.

10 Summary and revisin (need a cl pic here.maybe a pic f smene ding push-ups!) 1. The exchange rate is defined as the price f a currency in terms f anther r the price f a currency in terms f a (trade weighted) basket f ther currencies. 2. Demand fr a currency is largely a frm f derived demand. The demand fr the is determined by the underlying demand fr gds/services frm the EURO zne, investment in the EURO zne and speculatin in the EURO. 3. A flating exchange rate regime means that the exchange rate is determined by the market frces f supply and demand. 4. In a flating exchange rate regime, a fall in the price f a currency is called depreciatin while an increase in the price f currency is called appreciatin. 5. The demand fr a currency shifts due t a. A change in exprt demand b. A change in relative inflatin c. A change in demand fr freign inward investment d. A change in freign trade partners incme e. A change in dmestic interest rates f. Speculative buying f the currency 6. The supply f a currency shifts due t a. A change in demand fr imprts b. A change in relative inflatin c. A change in dmestic incme d. A change in freign investment abrad e. A change in freign interest rates f. Speculative selling f the currency 7. Other determinants f the exchange rate include: a. PPP thery e.g. that exchange rates in the lng run will run inversely t inflatin rates since higher dmestic inflatin will lead t increased imprts and hence an increase in supply f the dmestic currency. b. Gvernment deficits and debt; there will be strng expectatins-based speculatin that deficits and debt ultimately weaken an ecnmy. This decreases the demand fr the currency f the debtr natin. 8. A depreciatin/appreciatin can in turn affect: a. Dmestic GDP (a depreciatin can result in increased exprt revenue) b. Inflatin (increased exprts stimulate AD which can result in inflatin) c. The current accunt (increased exprt revenue is accunted fr as an inflw in current accunt) d. Unemplyment (increased exprts which stimulate AD can result in lwer unemplyment) e. Gvernment debt servicing (a depreciatin f the hme currency has the effect f increasing the cst f freign debt servicing)